2.16.2016, 9:09:00 AM

Corporate duties of bank directors in North Carolina (part 3)

In Part 1, we introduced you to the history of Cooperative Bank and the background of Federal Deposit Insurance Corporation v. Rippy, 799 F.3d 301 (4th Cir. 2015), also known as FDIC v. Willetts. In Part 2, we further explained the history of the litigation.

The Fourth Circuit’s ruling is in harmony with the majority of cases regarding the business judgment rule.
What the Fourth Circuit does not say is just as important as what it does. The Fourth Circuit does not say that the ultimate decision to make these 86 lot loans and 9 commercial loans was actionable. It did not rule that the business judgment rule prohibited making these failed loans. Instead, Rippy is in alignment with most other business judgment rule cases.

The FDIC had a qualified expert witness who testified that the process used to approve the loans, which ultimately soured, did not meet generally accepted sound banking practices. This was enough to rebut the presumption of the business judgment rule. The Court was not second-guessing the decision to make these loans; but it concluded that the officers had failed in the process of deliberation and consideration before funding the loans. In other words, judges “do not measure, weigh, or quantify directors’ judgments. We do not even decide if [a director’s judgment] is reasonable . . . Due care in the decision-making context is process due care only. Irrationality is the outer limit of the business judgment rule.” Brehm v. Eisner, 746 A.2d 244, 264 (Del. 2000) (emphasis in original) (and stating “irrationality” can equate with the waste of corporate assets test); State v. Custard, 2010 NCBC 6, 18 (N.C. Sup. Ct. 2010) (“North Carolina courts have frequently looked to the well-developed case law of corporate governance in Delaware for guidance.”).

Under North Carolina (and Delaware) law, absent bad faith, conflict of interest, or disloyalty, an officer or director’s business decisions “will not be second-guessed if they are the product of a rational process, and the officers and directors have availed themselves of all material and reasonably available information.” State v. Custard, 2010 NCBC 6, 18 (N.C. Sup. Ct. 2010) (citing In re Citigroup Inc. S’holder Derivative Litig., 964 A.2d 106, 124 (Del. Ch. 2009). As quoted with approval by the North Carolina Business Court:

[C]ompliance with a director's duty of care can never appropriately be judicially determined by reference to the content of the board decision that leads to a corporate loss, apart from consideration of the good faith or rationality of the process employed. That is, whether a judge or jury considering the matter after the fact, believes a decision substantively wrong, or degrees of wrong extending through “stupid” to “egregious” or “irrational”, provides no ground for director liability, so long as the court determines that the process employed was either rational or employed in a good faith effort to advance corporate interests. To employ a different rule-one that permitted an “objective” evaluation of the decision-would expose directors to substantive second guessing by ill-equipped judges or juries, which would, in the long-run, be injurious to investor interests. Thus, the business judgment rule is process oriented and informed by a deep respect for all good faith board decisions.

Courts will not second-guess the ultimate decision arrived at, so long as the procedure utilized by boards and officers is sufficient. Directors and officers are reasonably informed in making corporate decisions if they have considered the material facts to a transaction which were reasonably available at the time. Ehrenhaus v. Baker, 2008 NCBC 20 (N.C. Sup. Ct. 2008) (citing Smith v. Van Gorkom, 488 A.2d 858, 874 (Del. 1985).

Without expressly stating it, Rippy means that procedure matters. The officer’s failed to comply with recognized banking practices in obtaining loan approvals. When the officers failed to “avail themselves of all material and reasonably available information” they “did not act on an informed basis” and thus were not entitled to the protection of the business judgment rule.

The Fourth Circuit also ruled that the Great Recession was not an intervening or superseding proximate cause as a matter of law.

Intertwined and underlying the manager’s defenses is the narrative that the real estate bubble and financial collapse of the late 2000s was the real proximate cause of the bank’s failure or was an intervening or superseding cause. Indeed, the managers argued that the burden was on the FDIC to prove that the manager’s conduct in approving 86 loans, and not the exogenous factors of a nationwide real estate collapse, frozen credit markets, and a bank panic, was the real (proximate) cause of the bank’s failure. The Fourth Circuit took note of this argument, stating:

Certainly, it is convenient to blame the Great Recession for the failure of Cooperative, and in turn for the losses sustained by the FDIC-R when it took over the Bank. However, there is evidence in the record, as outlined above, that suggests that “in the exercise of reasonable care,” the Bank officers could have “foreseen that some injury would result from their acts or omissions, or that consequences of a generally injurious nature might have been expected.” Even before the Recession, exam reports from both of Cooperative’s regulators indicated that the Bank was utilizing unsafe practices. And while the Recession undoubtedly contributed to the failure of the Bank, it may have been only one of many contributing factors. This is a genuine issue of material fact, and thus this is a question for a jury.

This paragraph has particular salience. Under the Fourth Circuit panel’s opinion, the FDIC’s case survives summary judgment while admitting that the Recession “undoubtedly” was a partial proximate cause of the bank’s failure.

The Fourth Circuit also affirmed the entry of summary judgment on all claims of gross negligence against all directors and officers.

Settlement.

The panel remanded the case back to Judge Boyle for a trial on the ordinary negligence and breach of fiduciary duty claims against the officers. However, the Bank had the option of petitioning for en banc review before the full Fourth Circuit rather than just a three-judge panel.

Ultimately, on January 6, 2016, a consent order and settlement agreement were filed with the Court. The document stated that The Cincinnati Insurance Company would pay $4.1 million on behalf of the remaining defendants to settle all outstanding claims, and that "no additional funds will be sought from the remaining defendants."

Takeaways for bank directors purchasing D&O insurance

Corporate boards and officers, and particular bank boards and officers, should review and follow their internal procedures regarding corporate decision-making in accordance with Rippy. In addition, banks should always have adequate D&O insurance coverage to protect their directors and officers against these types of claims.

Bank directors and officers must also be aware of the FDIC’s recent warnings regarding the increased use of exclusions in commercial market D&O policies. The FDIC did not point out any particular exclusions, although it was most likely referring to the regulatory action exclusion. Post-recession litigation by the FDIC has already generated coverage litigation, some of which has upheld a broad regulatory exclusion in certain D&O policies.

In that statement, the FDIC has encouraged “each board member and executive officer to fully understand the answers” to at least four specific questions regarding D&O insurance coverage:

What protections do I want from my institution’s D&O policy?

What exclusions exist in my institution’s D&O policy?

Are any of the exclusions new, and if so, how do they change my coverage?

What is my potential personal financial exposure arising from each policy exclusion?

The FDIC’s guidance also reminds bank managers that “FDIC regulations prohibit an insured depository institution or depository institution holding company from purchasing insurance that would be used to pay or reimburse an institution-affiliated party (IAP) for the cost of any civil money penalty (CMP) assessed against such person in an administrative proceeding or civil action commenced by any federal banking agency.” This prohibition prevents the purchase of insurance to indemnify the bank for paying civil money penalties on behalf of its managers. This would include penalties imposed when an officer or director violates a law or regulation, commits an unsafe banking practice, breaches a fiduciary duty, or engages in willful misconduct. The FDIC did not give any guidance regarding whether an individual manager can purchase their own personal umbrella policy to indemnify them for civil monetary penalties.

While this decision is interesting, it does not actually change the law in North Carolina regarding the legal liability of corporate directors and officers. What the opinion does is highlight the need for a bank’s directors and officers to follow their own procedures and for the bank to provide D&O insurance for its directors and offices in case these procedures were not followed.
A version of this article originally appeared in the Professional Liability Underwriting Society's Journal.
_______________
11 Id. at 312.

12 Note that defendant Fredrick Willetts, III was both CEO and Chairman of the Board of Directors. He was both an officer and a director. The exculpation statute provides no protection to Mr. Willetts for violations of the duty of care committed as an officer.

13 Rippy, 799 F.3d at 313.

14 In this way, the business judgment rule operates as a standard of judicial review, and not simply as a standard of board and officer conduct.